Chapter 4

Inflation in Pakistan: An Historical Perspective

Pakistans economy over the years showed fairly good economic growth with a modicum
of price stability, despite the fact that it has gone through a massive devaluation, oil
shocks, crop failures, floods, Afghan war, earthquake, rapid political changes, military
authoritarianism, war on terror and inconsistency of economic and development policies.
It surprised observers by surviving in the worst economic crises but failed to deliver in
times of macro stability. The economy has seen GDP growth rate of 6 per cent or more,
almost 19 out of 38 years of the period of this study and inflation rate of less than 5
percent only 5 times. It is obvious that GDP growth has been inflationary in Pakistan and
inflation lies low in terms of priorities. Inflation became a matter of concern only since
around the start of the 1990s, coinciding with the start of structural adjustment
programme with the IMF.
4.1 Historical account of inflation in Pakistan
Pakistans inflation rate over the years has been satisfactory according to most analysts.
In the 1970s its average was 11.9 per cent per annum, in the 1980s the average fell to 7.5
per cent, in 1990s it rose again to 9.7 per cent and the average of 2000-08 is 6.4 percent.
Rapid increase in the oil prices, wheat shortage, increase in money supply, growth rate in
commercial banking and increased credit availability to private sector are the highlighted
factors of inflation rate to exceed the average. Inflation process in Pakistan confirms the
theory whenever high inflation takes place it short-lived.
Most analysts adopted the bottom up approach for explaining inflationary process in
Pakistan. Sectoral changes resulting from oil price hike or wheat price movements are
only a part but not the inflation in which all prices move in same proportion. If we divide
inflationary process into its components, in 1970s supply shocks were the major reason
and in 1990s monetary expansion, decline in total factor productivity, lack of fiscal
discipline, administered prices were the causative factors.
Inflation in Pakistan ranges from 3 per cent to 27 percent. On average Pakistans inflation
rate over the period of analysis is 8.8 per cent. With the standard deviation of 5.3 per
51

cent, it is moderately high and may be one of the causative factors of uncertainty which
can hamper growth and development.
Figure 4-1: Trend of inflation rate in Pakistan
30

INFLATION RATE

25
20
15
10
5
0
1970

1975

1980

1985

1990

1995

2000

2005

The graphical representation in Fig. 4.1 gives peaks of inflation. In 1973-75 inflation was
at its peak ranging from 26.7 per cent to 20.9 per cent. The second round of high inflation
happened in 1980-81; it reached 12 per cent. Other peaks were observed in 1991-92 when
inflation touched 11.8 per cent; in 1994-95 inflation went up to 13 per cent. 1990s was
the decade of high volatility. In general, food and non-food inflation with expansionary
monetary policy were the causative factor of inflation. This is the time when Structural
Adjustment Programme was started and markets began to be deregulated. The State Bank
got its autonomy and exchange rate regime switched from fixed to free float. The period
from 1999-2003 was marked by price stability and inflation rate hovered around 3-4 per
cent. Inflation rate rose to 9.8 per cent in 2004, this time catching the attention of policy
makers with urgency for controlling prices. In 2008 inflation rate reached 14 percent
which is inimical to growth as total factor productivity is on decline, agricultural sector is
not clicking and energy prices have broken all records. 2009 is likely to end up with an
inflation rate of 20 per cent. There is thus urgency for controlling inflation.

52

4.2 Growth and inflation relation

In the period of the study, average annual growth rate of real GDP was 5.4 per cent with a
standard deviation of 2.5 per cent. It ranges from 0.5 per cent to 11.4 per cent. GDP
growth rate remained below 5 per cent until late 1970s, in 1980s average real GDP
growth rate was 6 per cent, the 1990s experienced lowest average growth rate of 4.6 per
cent and average of 2000-08 stands at 6 per cent. The key drivers of real GDP growth in
Pakistan were good harvests, high growth rate of large scale manufacturing sector, strong
performance of services sector, activity in housing sector, global economic environment,
reliance on markets and windfall gains. The need is always felt for consistent market
based macro policies.
In economic literature, a debate exists on growth- inflation trade-off. Thirlwall and
Barton (1971) report a positive relationship between inflation and growth. Gillman et al.
(2002) indicated that the reduction of high and medium inflation (double-digit) to
moderate single-digit figures has a significant positive effect on growth for the OECD
countries. Ghosh and Phillip (1998) found that at very low inflation rates, growth and
inflation are positively correlated. However, they are negatively correlated at high level
of inflation.
The diagrammatic exposition (Fig. 4.2) of annual time series data of GDP growth rate
and inflation rate over the period of analysis suggested no significant relationship
between the two variables, though on average it could be said that growth performance
was dismal in the years of high, double-digit inflation.
As illustrated in Fig. 4.2, growth rates remained below 5 per cent until late 1970s during
which inflation remained mostly double-digit and it could be confirmed in this sense that
in 1986 inflation rate was at its lowest point which followed the high growth rate of 1985.
In 1990s inflation rate was in double- digit and economy had to face poor growth
performance. Peak analysis of the real GDP growth and inflation rate clears the
theoretical debate that there exists a trade-off between high inflation rate and low
economic growth.

53

Figure 4-2: Relationship between GDP growth rate and Inflation rate
28
GDP GROWTH RATE AND INFLATION RATE
24
20
GDP

16

INF

12
8
4
0
1970

1975

1980

1985

1990

1995

2000

2005

In 1974 inflation was at its historical height of 27 per cent and GDP growth was 3.5 per
cent. In 1975 inflation dropped a little to 21 per cent and GDP growth recovered to 4.2
per cent. 1n 1980-81 no clear-cut trade-off was there but a positive trend existed.
Inflation and growth rate were both high in double- digit. The last decade portrays a
mixed trend and no clear picture can be observed. On average it could be suggested that
growth performance was dismal in the years of double-digit inflation rate in Pakistan.
The lowest observed rate of inflation in 1986 was preceded by a very high growth rate in
1985. In 1990s inflation rate was in double-digit and the economy had to face poor
growth performance. It, therefore, can be suggested that high inflation is one of the
causative factors for low growth rate in the economy but we cannot generalize.
There exists a weak positive correlation of 3.9 per cent between inflation and real GDP
growth rate. This low value of correlation suggests that no significant relationship exists.
The data of real GDP growth and CPI inflation rate showed that on average growth rate
was 5.4 with a standard deviation of 2.5 and the same values for inflation rate were 8.8
with standard deviation of 5.3. Inflation rate showed greater volatility compared to GDP
growth rate which is an indicator of uncertainty. When inflation rate was above 9 per cent
(threshold level) in the economy it generated GDP growth rate of 6 percent and above for

54

6 times out of 19 times of the study. It is 32 per cent of the entire high growth period of
the country.
Table 4-1: Analysis of Inflation and GDP Growth

Inflation
Rate

<5.00
5.00 - 8.66
8.67 - 12.32
12.33 - 15.99
19.67 - 23.33
23.34+
Total

<= 3.00
2
4
2
0
1
0
9

GDP Growth
4.00 6.00 5.00
7.00
2
1
3
9
3
3
1
0
0
1
1
0
10
14

8.00 - 9.00
0
1
4
0
0
0
5

Total
5
17
12
1
2
1
38

The simple statistics of inflation rate and GDP growth rate in Table 4.1 indicate that on
average inflation rate is almost 9 per cent over the estimation period and growth
performance on average is 5 per cent. This again suggests that high inflation could be
associated with low growth of the economy.
4.2.1 Impact of Inflation on Sectoral Growth
Inflation not only hurts overall growth but also disturbs the sectoral growth and
distribution of GDP. As Fig. 4.3 clearly shows, inflation strongly affects the
manufacturing growth rate as compared to the other sectors. Decline in total factor
productivity in manufacturing sector can be extended as one of the major reason for
inflationary pressures in the economy. (See Annex-4-I)
Figure 4-3: Impact of inflation on sectoral growth
15.0
10.0
5.0
0.0
1965- 1970- 1978- 1983- 1988- 1993- 1998- 200370
78
83
88
93
98
05
8
Agriculture

Manufact

Others

Inflation rate

55

4.3 Relationship between inflation rate and money supply

There has been a long debate in economics regarding the role of money in an economy,
the starting point being the quantity theory of money, which states that there is la ong
term relationship between money and prices when the velocity of money is constant.
Keynes rejected the quantity theory of money as a basis for monetary policy. He rejected
the theory of loanable funds as well. The monetarists restated the quantity theory of
money in terms of theory of money demand. According to Friedman, (1983) its chief
exponent, increase in money supply , via portfolio adjustment, leads to increase in prices.
Further, prices increase due to unanticipated inflation in the economy4.
After the independence of the country, the newly set up SBP adopted the monetarist
approach and the main objective was price stability and development of financial sector
in Pakistan. In this era, monetary policy gave importance to the asset side of the banking
system. Credit to government was the main source of monetary expansion. In 1960s the
policy of liberalization was adopted and for the first time in the history of Pakistan credit
to the private sector was extended liberally and this trend continued until the banks were
nationalized in early 1970s. In general, monetary expansion in Pakistan depended on the
projected growth rate and projected monetization requirements in the economy.
Annual average growth rate of broad money supply was 15.4 per cent with a standard
deviation of 6.4, whereas GDP growth rate during 1970-2008 was 5.4 per cent with a
standard deviation of 2.5. There is again weak positive correlation between broad money
supply and real GDP; it was found as 8.1 per cent. Therefore, it could be said that money
supply and output growth have some degree of positive but weak association.
In Pakistan money supply and inflation rate have experienced high growth rates but these
have not influenced the output growth apparently. There is a very weak correlation
between growth rate in broad money and inflation rate which was 14.1 per cent. The
average growth in broad money was 15.4 percent with the standard deviation of 6.4
percent. Average inflation rate was recorded as 8.8 percent with the standard deviation of
5.3. By looking at Fig. 4.4 it could be inferred that expansionary monetary policy resulted
4

Friedman (1983: p. 16)

56

in a high inflation rate in the next period. But inflation in Pakistan is more volatile as
compared to money supply.
Figure 4-4: Relationship between broad money Supply and inflation rate
35

INFLATION RATE AND GROWTH RATE IN M2

30
25
20
15
10
5
0
-5
1970

M2G
1975

1980

1985

1990

1995

2000

INF
2005

The trend in Fig. 4.4 shows that both inflation rate and growth in broad money supply
follows the trend and fluctuations. In 1970s when inflation increased due to supply shock,
money supply also increased due to massive devaluation of the Pakistan rupee. Inflation
rate varies from 2 per cent to 27 per cent whereas money supply changes from 1 per cent
to 33 percent. One can conclude that inflation is high when broad money supply increases
rapidly in the economy.
Table 4-2: Descriptive Analyses of Broad Money Growth, GDP Growth Rate and
Inflation Rate - 1970-2007
Statistics

M2G

GDPG

CPI

NXR

Mean

15.40

5.20

8.79

26.39

Median

16.07

5.06

7.80

18.00

Standard Deviation

6.43

2.49

5.68

19.09

Kurtosis

4.71

2.89

5.34

2.022

Skewness

0.89

0.18

1.56

0.73

57

Table 4.2 shows that the inflation rate, nominal exchange rate and money supply are
highly volatile as have very high standard deviation compared to GDP. In a managed
floating exchange rate regime, the role of monetary policy is limited as it is subservient to
the imports transmitting countries exchange rates. CPI and growth rate in broad money
supply are highly volatile series. For observing the trends in CPI, broad money supply
(M2), GDP and market exchange rate (MXR) we plot the log series against time (See
Annex-4-II). The line graphs show upward trend during the period of 1970-2007. One
important conclusion which can be drawn is that inflation rate, money supply, nominal
exchange rate and output series are positively related.
4.4 Relationship between interest rate and inflation
Interest rate is the price of using liquidity. It is very important that it should depict the
risk and real cost of holding money for the decision between speculation and investment.
There are various interest rates in Pakistan, such as call money rate, coupon rate, discount
rate, T-bills rate, and Karachi Interbank Borrowing Offer Rate (KIBOR). Call money rate
is the interbank lending and borrowing rate without collateral. Coupon rate is the interest
rate paid on bounds on biannual basis. Discount rate is the three days repurchase order
rate and it is a facility provided by the SBP as a lender of last resort. T- Bill rate is the
rate charged on Government borrowing. KIBOR rate is also an interbank offer rate. It is
used for interbank borrowing without collateral. It is determined on the basis of bids,
which is why it is called a consensus rate. With tenure one to three years, it is considered
as the benchmark for corporate lending. In this study we using call money rate as an
indicator for interest rate because it is the rate which central bank determines and can
influence the money market and the level of real income and the price level.
In Pakistan a divergence exists between different interest rates like deposits rate, lending
rate and call money rate. This divergence leads to segmentation and creates arbitrage in
the bonds market of Pakistan, which leads to inefficiency. Various authors have pointed
out the need for narrowing the spread rate in Pakistan for improving the asset quality and
banking activities. Call money rates are used as a proxy of interest rate in this study. It is
short term interest rate.

58

Figure 4-5: Relationship between Inflation Rate and Call Money Rate
30

Relationship between Inflation rate and Call Money Rate

25
20
15
10
5
0
1970

INF
1975

1980

1985

CALLMON
1990

1995

2000

2005

Call money rate moves with the changes in inflation rate. Average of call money rate
during 1970-2008 is 8.15 per cent and the average inflation rate for the same period is
8.78 per cent. Inflation rate is more volatile; its lowest value is 3.1 per cent and highest
value is 27 per cent compared to the interest rate, the lowest value is 2.14 per cent and the
highest is 12.1 per cent. The standard deviation of inflation rate is 5.19 and for the call
money rate 2.29. Interest rates are usually controlled in Pakistan because of its direct
implications for investment, and due to underdeveloped financial market. The rigidity in
the interest rates has negative impact on savings and on the growth of bonds market. It
provides only a limited portfolio for investment in Pakistan. We can sum up that when
the State Bank of Pakistan increases money supply which generates inflation, it raises
interest rate to offset the price effect. There exists a weak positive correlation of 24 per
cent between inflation rate and call money rate in Pakistan.
4.5 Relationship between inflation rate and exchange rate
Expectations play the most important role in determining the value of currency and
inflation rate at a given interest rate. Increase in money supply leads to the depreciation
of currency in foreign exchange market. The chain of causation runs like this: as money
supply increases, it generates inflation, which raises interest rates and hence depreciates
the currency in foreign exchange market. When the domestic currency depreciates it
increases the imported prices, such as raw material, which leads to increase in the cost of

59

production and in turn increases the domestic prices and change the aggregate demand
and hence generate inflation.
Usually movements in exchange rate affect the monetary policy stance and the central
bank has to adjust monetary variables in the economy. If Pakistans currency depreciates
in the foreign market then it exerts pressure on State Bank to decrease the money supply
either via interest rate effect or by applying quantitative controls. In Pakistan exchange
rates were fixed until 1990s. No clear-cut relationship exists between the two variables.
Figure 4-6: Relationships between Market Exchange Rate and Inflation Rate
70

MARKET EXCHANGE RATE AND INFLATION RATE

60
50

MXR

INF

40
30
20
10
0
1970 1975 1980 1985 1990 1995 2000 2005

4.6 Impact of inflation on saving and investment

Savings and investment are the two basic macro fundamentals which give a true picture
of the economy. Economic literature explains that a country is poor because of low
savings and investment. A number of studies concluded that there exists a positive
relationship between GDP growth, investment and saving. When inflation increases in an
economy it erodes the value of money and people prefer to spend than to save. If people
expect higher inflation and interest rates are low as in the case of Pakistan, households
prefer to consume and fixed interest rates lower the cooperate saving. It would generate
uncertainty in the economy. Interest rates and savings are widely accepted in economic
theory as determinants of investment. Money supply increases prices which in turn
increases the interest rates which ultimately appear as low investment and low savings.
Inflation negatively affects savings and investment due to the fewer alternatives available
for offsetting its effects.
60

Historically speaking, Pakistan is one of the lowest savers in the world. The Government
has launched various schemes for mobilization of savings with limited success. The data
of national saving shows that the highest saving rate was 23 per cent and lowest -10 per
cent of GDP with the standard deviation of 7.5 per cent, which makes national saving rate
very sensitive to changes in the economic conditions. Average national savings rate was
12 per cent during 1970-2008 (See Annex-4-III). These facts shed light on the
unsustainable macroeconomic growth of Pakistan. Saving rate is not only low and
volatile but also negatively correlated with inflation rate. The correlation coefficient is
found to be -31 per cent. It confirms that in a high inflationary environment households
and corporate sector prefer not to save.
Average total investment was 16 per cent with a standard deviation of 11 per cent. There
exists a strong positive correlation (74 per cent) between total investment and inflation
rate (See Annex-4-IV).

Figure 4-7: Relationship between National Saving, Total Investment

and Inflation Rate
25.00
20.00
15.00
10.00
5.00
0.00
70s
inflation rate

80s
national saving

90s

2000-08

total investment

The average analysis of inflation rate, national savings and total investment confirms that
high inflation contributes to total investment due to the interest rate effect and capital
gain effect in the short run. One cannot draw this conclusion for savings in Pakistan.
When inflation takes place, on one hand people prefer to consume due to substation
effect decreases the savings rate and, on the other hand, increased income due to high
inflation generates the income effect which means more income will generate more
61

savings. Simple statistics show that savings are negatively related to inflation rate in
Pakistan. It is not only the high inflation but also the associated uncertainty which
adversely affects the saving rate in Pakistan (See Annex-4-V).
4.7 Issues in measurement of inflation rate
Increase in prices can be measured in various ways. The most commonly used indicators
in Pakistan are Consumer Price Index (CPI), the Wholesale Price Index (WPI) and
Sensitive Price Indicator (SPI). Each of these measures faces practical difficulties in
compiling averages of averages of prices. Consumer Price Index is most widely used in
Pakistan and elsewhere for the measurement of inflation rate. It has an upward bias due to
quality effect, substitution effect, new goods effect and outlet effect. In addition, there is
an urban bias and coverage (items) bias.
Due to problems associated with the impact of inflation and in spite of issues related to
measurement, controlling inflation is agenda item number one in all types of economies.
If we relate this thinking to the source of inflation, it points towards the effectiveness of
economic policies. An implicit consensus has somehow emerged that sound monetary
policy is more effective in influencing economic growth via price stability in a
developing country, even though markets have not yet completely developed.
Measuring prices is immensely important for measuring economic activity and inflation
rate in economy. But it is not easy to have exact calculation of general price level. In
1987, ILO published the resolution on the standards of price measurements. In 1996,
Boskin report was published and a debate started on the measurement issue of price
indices. Consumer Price index has an upward bias in estimating prices. In Pakistan the
official measure of inflation is CPI, while Wholesale Price Index (WPI) and Sensitive
Price Indicator (SPI), a subset of CPI, are also issued. Monetary policy formulation for
controlling inflation depends on the accuracy of the price index. The choice of price
index will enable the central bank to answer why there is need to control inflation at all.
CPI is a weighted index which measures price change at retail level and in aggregate
form provides estimates of general price level. There are certain measurement issues. It
measures the price change in private consumption expenditure. If inflation in a country is

62

due to public spending or budget deficit then any measure of inflation should incorporate
changes in prices for public consumption.
CPI in Pakistan is measured on the basis of monthly prices and the base is revised after
10 years. It is a long time to compare two baskets of the goods. In UK, CPI base is
changed every year. It makes prices change in one month comparable with the other
month more realistic. It also provides a remedy for substitution bias. Inflation rate
computed on the basis of 10 years base period makes comparison irrelevant. Government
of Pakistan has decided to change the base time period from 10 years to 5 years but it has
not yet been implemented [See Federal Bureau of Statistics (2008)]. The CPI covers the retail
prices of 374 items in 35 major cities and reflects roughly the changes in the cost of
living of urban areas, 71 markets and 10 commodity groups and covers 92 commodities.
It took price quotations from 106216 retail shops. [See Federal Bureau of Statistics
(2008)]. CPI in Pakistan has a market selection bias. Markets have been selected on the
basis of volume of sales. It further assumes that majority of the urban consumers make
their purchases from these markets. Weight for each CPI item has been developed from
Family Budget Survey and represents the percentage expenditure share of a specified
item in the total expenditure of the household on all CPI goods and services. There are
four income groups: the lowest income group has income level upto Rs. 3000 and highest
income group is Rs 12000 and above. The highest weight assigned in measurement of
CPI is for food which is 40 percent. When minimum wage is Rs. 6000 and the official
poverty line for the average family size also works out to be higher, the low income
group of Rs 3000 reflects income class bias. Prices for CPI are collected directly from the
retail shops according to a predetermined time table. For the food and beverages group,
prices are collected on 11-14 of each month. For Apparel, Textile, etc prices are collected
on 1-3 of every month. The collection of unit price data on specific dates is arbitrary and
source of bias. With this type of rough and incomplete measure, one cannot predict the
dynamic relationship of a variable. There is an urgent need to revamp the methodology
for measuring inflation in the economy.
Further, there is the need to measure and exactly quantify the bias in measurement of
inflation, which is either overstates or understates the actual inflation rate in the
economy. Whatever the actual inflation rate, however, it does not lessen the
63

responsibility of monetary authorities for controlling it. It is not the inflation rate but its
cyclical nature and its capacity to create uncertainty, which makes a case for controlling
it. Once monetary authorities are committed to control inflation, they need a sophisticated
policy and a realistic measurement.

64